Since 2006 retirement savers have been able to contribute to Roth accounts via their retirement plans at work. Known better as the Roth 401(k), these unique retirement plans allow you to save after-tax dollars in an account that grows tax-free and allows for tax-free distributions during retirement.
Not every employer offers the Roth 401(k) as a feature available in their retirement plan, but when they do you should take advantage of the opportunity.
Here are 5 reasons why you should contribute to your company’s Roth 401(k).
No Income Limits. The biggest reason why many people don’t have Roth IRAs is that their income exceeds the allowable limits for people making Roth contributions. For married couples filing jointly Roth IRAs are phased out if your adjusted gross income exceeds $186,000. Single taxpayers are phased out at $118,000. The exact income limits and phase outs can be found by visiting the IRS.gov website.
Roth 401(k)s have no such income limits, however. If your company offers a Roth 401(k) you may make contributions to your account no matter how high your income. For people at higher incomes this may be the only opportunity to contribute to a tax-free Roth account.
Larger Contribution Limits. A Roth IRA caps your contribution at $5,500 per year ($6,500 annually if you are age 50 or older). The Roth 401(k) has the same contribution limit as the traditional side of your 401(k) plan. IRS rules allow savers to contribute up to $18,000 per year, plus an additional $6,000 for those age 50 or older.
For older savers with the cash flow, that means up to $24,000 per year can be added to a tax-free retirement account. Even with no appreciation of your investment you could set aside up to $360,000 tax-free for retirement between ages 50 and 65.
Invest well and that number could be much higher.
Tax-free Distributions. Like Roth IRAs, distributions from the Roth 401(k) are tax-free. That’s the big benefit of all Roth accounts including the Roth 401(k) – tax-free distributions!
Here is why: Taxable distributions from retirement accounts affect more than just your income tax bracket in retirement. They also allow you to maintain a lower tax bracket which brings additional benefits. For example, a low tax bracket determines whether or not capital gains are taxable in your non-retirement accounts, the percentage of your social benefits that are taxable, how much you pay in Medicare premiums, and more.
Future Tax Rates May Go Up. The downside of the Roth 401(k) is that contributions are made with after-tax dollars. This means that you give up a tax benefit today (contributions to a traditional 401(k) are deducted from your gross income before taxes) in exchange for a tax benefit tomorrow. If your tax bracket is higher in retirement, the Roth IRA is a big win for you because distributions avoid the higher tax rates of the future.
Exactly what tax rates will be like when you retire – and for the remainder of your life after that – no one knows. What we do know is that tax rates today are as low as they have ever been and the U.S. national debt exceeds $19 trillion. Throw in unfunded liabilities like Medicare and Social Security and the total tab is estimated to exceed $100 trillion. These numbers don’t account for the debt and liabilities of state and local governments which also tax your income.
The net result of all this outstanding debt is that the Federal and state governments will be under increasing pressure to raise tax revenue in the future.
Roth 401(k)s are Worth More, maybe way more than a traditional 401(k). Imagine two accounts, both are worth $1 million. One is a traditional 401(k). The other is a Roth 401(k). If you could pick just one for your retirement, which would it be?
If you picked the Roth, you would likely be ahead by hundreds of thousands of dollars. When you have a traditional 401(k) you owe some of that money to the IRS – maybe as much as a third or more depending on your tax bracket. With a Roth 401(k) the IRS has no claim to your money. 100% of the Roth 401(k) belongs to you and your beneficiaries.
An analytical person would point out that the taxes saved by contributing to the traditional 401(k) could also be invested and would narrow the gap between the two accounts. But that is only true if today’s tax rates stay the same (or go down) when you retire AND you have the discipline to actually invest the money that was saved when you added to your traditional 401(k).
Another way the Roth 401(k) is worth more – no Required Minimum Distributions (RMD). If you leave your Roth account as a 401(k) when you retire, you will be required to take a minimum distribution (RMD) when you turn age 70 ½. However, if you roll that Roth 401(k) over to your Roth IRA, the RMD is avoided since Roth IRAs have no RMD requirement.
Unlike a traditional 401(K) from which the government will force you to take out taxable distributions every year, your Roth 401(K) can grow tax-free indefinitely creating a larger source of tax-free money for you and your beneficiaries in the future.
For those at higher income levels or who have the cash flow to save more money, the Roth 401(k) provides a tax-free source of money to draw from in retirement. Roth 401(k)s allow you to pay less tax on your income, pay lower Medicare premiums and pass your assets on to your heirs tax-free.
How do you beat that?